In one sentence: After a detour about art and cars as investments, Phil recaps the six bad-CEO signs and then explains the three numbers (ROE, ROIC and debt payback from free cash flow) that are hard for management to manipulate, with CF Industries and his Horsehead mistake as examples, plus a look at boards.
Key ideas
- Rule #1 works beyond stocks. Danielle notes it applies to real estate and local businesses. Phil: buying a car or art hoping it rises is speculation; buying a collectable at a garage sale for half a flip price you know is investing. Art has some intrinsic floor, but no cash flow. [00:00–08:00]
- Recap of the six signs: pay tied to asset size, little own money in the stock, acquisitions that cut returns and add debt, selling stock below stated value, a puff letter, and focus on (adjusted) EBITDA. [09:00–14:00]
- The three numbers sit inside sign 3: ROE, ROIC and debt. They show whether management serves itself or owners. [14:00]
- Return on equity = earnings ÷ equity, where equity = assets − liabilities. At least 10%, preferably 15%+, and rising under this team. It shows how management uses your money. Phil flags that assets can be distorted by accounting (market value for securities, cost for private holdings) while liabilities are usually right. [16:00–20:00]
- ROIC = earnings ÷ (equity + long-term debt). With debt in the company, ROIC is lower than ROE. It makes management accountable for borrowed money too. Both fall quickly if they are buying poorly. Phil says some investors, perhaps including Buffett, would use ROIC if they could only pick one number. [19:00–22:00]
- Debt kills in public companies. In a restructuring, public shareholders are assumed wiped out while a private owner is likely to keep a stake. Phil cites the oil patch where firms go bankrupt to shed debt. [22:00–23:00]
- Debt payback test. Free cash flow should repay debt in at most about three years, and the number should be falling. CF Industries: about 10 years after 2014's debt load, four years the next year, about two and a half in 2015. [23:00–24:00]
- CF's red flag. It borrowed while keeping dividends. Phil says this echoes GM, which paid dividends on borrowed money to the end. If CF were owned by one person, he thinks they'd cut the dividend and pay down debt. [14:00–15:00, 24:00–26:00]
- Phil's Horsehead mistake: he let debt creep up while free cash flow fell, believing management that cost overruns were normal. He says he should have demanded a rights offering or asset sales when the numbers turned. [26:00–28:00]
- Judge the board too. Boards are often paid by and loyal to the CEO. Phil points to Ross Perot's account of the GM board after EDS was bought. His Coca-Cola example: Buffett's son on the board while CEO pay rose and shareholders gained nothing. Social pressure keeps directors quiet. [28:00–31:00]
- Follow the money. Cheap debt leads to buybacks at any price and acquisitions regardless of returns, with executives paid millions and leaving the next CEO the problem. Phil cites a $160M Exxon exit bonus as an example. If pay, debt and ROE move the wrong way, run. [31:00–34:00]
How it maps to RuleOne
- ROE, ROIC and debt-to-FCF are the numbers the screen can show for every stock. Read their trend over 3–5 years on /stock/TICKER/, not a single year.
- ROIC and ROE are in the Big Five set, covered in m4.
Buffett, Munger and Graham links
- Buffett on return on equity and keeping debt low: Berkshire's owner's manual and the 1979 letter on ROE as a yardstick.
- Buffett on boards and directors' independence: letters of the 1990s–2000s; I am not quoting them.
- Perot's book is not named in the audio, so I haven't named it here either.
Words to know
- Return on equity (ROE): earnings ÷ equity.
- Return on invested capital (ROIC): earnings ÷ (equity + long-term debt).
- Rights offering: offering existing holders the chance to buy new shares, used to recapitalise.
Try this
Choose a company on /stocks/ and read ROE, ROIC and debt over five years. Compute debt ÷ free cash flow. Is it under three years and falling? Is ROIC rising?
Check yourself
- Why will ROIC be lower than ROE for a company with debt?
Answer
Both divide the same earnings, but ROIC's denominator adds long-term debt. - What debt payback does Phil want?
Answer
Out of free cash flow in three years or fewer, and shrinking. - Why did Phil lose money at Horsehead?
Answer
He let debt rise while free cash flow fell and trusted management's reassurance instead of acting on the numbers.
Short quotes
"Follow the money in your corporation." (Phil, ~33:40, auto-transcribed, paraphrased)